Since their introduction in the mid-1990's, equity-indexed annuities (EIAs) have become very popular with annuity buyers. These products combine security of principal with participation in equity index returns. They are therefore appealing to buyers who are risk-averse, but nonetheless want a chance to achieve the higher potential returns associated with equities. Recent sales statistics show EIAs making up 40% or more of life insurance general-account annuity sales, compared with almost none a decade ago.
In order to provide EIAs on a profitable basis, a life insurance carrier must have an appropriate investment strategy and hedging system in place. The potential for large losses if a carrier invests only in bonds, for example, but offers guaranteed returns based on stock-market performance is obvious. See, for example, U.S. Pat. No. 6,049,772 for a description of the hedging activity and software required to support the issuing of EIAs.
Since the sharp decline in U.S. stock prices in early 2000, retail investors have developed a much greater appreciation of the risks of direct equity investment. As a result, they have been increasingly willing to consider EIAs, because these are retirement savings vehicles that eliminate risks to principal while providing for equity-linked returns.
Similarly, as defined-benefit pension plan participation declines, retail investors are becoming increasingly aware of mortality risk: in this case, the risk that a retiree may outlive his or her retirement assets. A defined benefit pension plan provides retirees with income for life, and can reduce the associated mortality risk by means of “mortality pooling”. When mortality is pooled, the greater benefits that may be paid to a longer-lived retiree can to a large degree be offset by lesser benefits paid to a more short-lived retiree.
The continuing decline in defined-benefit pension plan participation means that retirees, if they restrict themselves to conventional investments like stocks and bonds, are increasingly being forced to accept mortality risk. They must therefore plan for the “worst case” (living to an advanced age) and budget accordingly.
However, mortality pooling can also be provided by life insurance carriers. By making a guaranteed lifetime income available to annuity buyers on a pooled basis, the need for any one buyer to invest for the “worst case” is eliminated, and so a higher level of income can be guaranteed for a given starting principal amount. Any one buyer's principal need only provide for the “average case”, not the “worst case”.
The guaranteed lifetime income benefit being described should not be confused with annuitization, i.e. the purchase of a single-premium immediate annuity (SPIA). SPIA's are described in, e.g., Life Insurance (10th edition) by S. S. Heubner & Kenneth Black.
Although both the EIA guaranteed lifetime income benefit and SPIAs rely on mortality pooling, there are a number of critical differences. An SPIA provides lifetime income, but does so on a basis that is extremely inflexible. For example, SPIAs typically allow little opportunity for the owner to access principal after income has started (although commutation of a certain portion of payments may sometimes be negotiated with a carrier). This is in fact one of the most commonly-voiced objections to the purchase of an SPIA: annuity buyers do not want to irrevocably surrender control of their principal to a life insurance company. Additionally, the vast majority of SPIAs do not provide for an income that can increase over time depending on stock index performance: instead, the income amount is fixed at issue and cannot vary thereafter. Furthermore, SPIAs do not allow for flexibility in the timing of payments over the course of a year. Typically, the same amount is paid out each month, regardless of the cashflow requirements of the owner.
Life insurance carriers have recently started to add guaranteed lifetime income benefits to variable annuities (VA), but once again these are distinct from the benefit described here. It is more difficult for a life insurance carrier to offer profitably with a VA, because they have much more basis risk, i.e., the risk that the financial instruments available for hedging will fail to match the behavior of the liability.
For example, many of the mutual funds offered in a typical VA are actively managed. This means that their performance will generally not match the performance of readily-available hedging instruments such as S&P 500 futures, for at least three reasons: 1) The asset mix held by the mutual fund manager will have the same investment return as a quoted index only by coincidence; 2) The mutual fund will have higher trading costs and expenses than would be typical of investment in, e.g., an unmanaged index through an exchange-traded fund; and 3) The fund manager may vary the allocation of assets between equities and fixed income in an attempt to outperform the market. Any such trading strategy will create additional optionality in the fund's values and make it harder for the life insurance carrier to hedge. Additionally, the owner of the variable annuity may transfer money from one fund to another or to a fixed interest account at unpredictable intervals, magnifying the basis risk problem.
Calculation of VA statutory reserves can be more complex and computation-intensive, at least given current regulatory requirements. VA reserves require calculation of a conditional tail expectation (CTE) of the greatest accumulated loss over a large number of scenarios and therefore require detailed Monte Carlo simulation of both assets and liabilities.
The VA lifetime income benefit also has disadvantages from the point of view of the buyer. A lifetime income benefit attached to a VA will typically not provide any accumulation guarantees in addition to the income benefit, so it may be harder to meet emergency cashflow or critical illness expenses using such a product.
Thus, there is a long felt need for a method and apparatus for performing pricing and reserving calculations for an equity-indexed annuity that does not restrict access to the principal, which allows income to increase with increases in the stock index, and which does not have rigid payment windows.